Applying Economics to American History

0:00It's very nice to be back in Houston today and to see such a splendid crowd here. I'm a little bit intimidated by it, even though I used to be a professor. I haven't been one for a long time, so I'm pretty comfortable talking to 10 or 15 people, but when I have hundreds like this, I start to shake. So if you see me quivering up here, you'll know why. But I wanted to talk to you today about something that I find terrifically exciting If I just said what's an exciting topic, probably the first thing you said would not be economic history. But it really is. And I've spent my entire adult life being excited by this subject.

0:46I'm still excited by it today. It never wore off. And one of the things that a lot of historians don't understand, even historians that are good in many respects, is the fact that in order to understand a great deal of history, perhaps not everything in history, but a great deal of the important events in history, you must understand at least basic economics. You have to. If you don't, you're going to make a mess of your interpretation of why things happened as they did. And so what I want to do in the short while I have to speak to you this morning is first of all give you a lightning-fast course in basic economic ideas and then I want to use these ideas to help you understand better a couple of important episodes in U.S. history and to show you that if you didn't understand these concepts you wouldn't understand A great many people, news people, professors, school teachers, members of Congress, either do not understand these ideas or disregard them consistently.

2:11We live in a world in which people are constantly misunderstanding what is happening, why it's happening. That's not a world you want to live in. You want to understand what's going on around you. So, it is essential that you master basic economics. This doesn't mean you have to get a PhD. In fact, that would spoil you. Because what you'd be taught in almost every PhD program in the United States would confuse you about basic economics and probably wipe it out of your mind and replace it with a lot of Mathematical gibberish, but basic economics is essential. What is basic economics? It's a branch of the human sciences, and by human sciences I'm referring to the sciences of why people act as they do.

3:05I'm not referring to human biology or human physiology or evolutionary biology or things like that that may have to do with humans, but aren't about why humans make the choices The greatest treatise in economics is actually a book called Human Action, and sometimes when people stumble upon that book, which was written by Ludwig von Mises, they're quite unclear about what it is. What is this book about? Human Action. That seems vague to them. But Mises developed a body of thinking that had originated earlier, particularly with The Theory of Money and Credit

4:43They are undertaking human action. If dust flies into my eye and my eye blinks, that's not human action. If I breathe, that's not human action. My physiological makeup compels my body, as it were, to breathe. I don't have to tell it that. I don't have to say, oh, I'd like a breath, I'll take one. Human action has to do with people's choosing means, using those means to achieve ends that they've selected for themselves to make themselves better off. Now, economics has to do with how people enter into relationships with others to exchange goods and services in a world where not everybody has the same thing everybody else has.

5:34People are in different positions, they have different skills, they possess different kinds of resources, and they discover that if they cooperate with one another by making exchanges, everybody can improve his position. So human action can be expressed in the form of exchanges, and that's what economics has to do with. the way people cooperate, notice I say cooperate, very frequently when people talk about economics they say it's about competition, but actually it's about cooperation, it's true that sometimes there's rivalry going on in the course of people making exchanges, but fundamentally what's going on here is cooperation, when I agree with somebody to make an exchange, that person and I are cooperating, and so economics has to do with how people exchange something. What is it that they exchange?

6:36It's not fundamentally that they exchange sticks and stones or they exchange goods and services. They exchange property rights. Property rights are claims on the behavior of other people. If I own my coat, it's saying that I'm the one who gets to decide how the coat will be used. I'm the one who will enjoy any benefits the coat yields, and if I choose to exchange it with someone to sell it or give it away, I'm the one who decides how to do that. So, rights to determine use, rights to appropriate benefits, rights to make exchanges, these are all parts of property rights which are claims on other people. Property rights aren't rights that I have against my coat. Property rights are rights I make against all of you, which restrict what you can do with my property.

7:33Property rights are essential for the successful functioning of an exchange economy. Because unless people have some security in their rights and against non-interference on the part of others, they don't know who can do what with what. And we have a world of confusion, reduced to kind of animal uncertainty and chaos. So property rights are at the root of economics. They allow exchange contracts to take place. And when these exchanges take place, they can take place directly, I can sell you my coat by just giving it to you, and in exchange you hand me a property of your own, that would be barter exchange.

8:20But in a complex world where there's division of labor and people don't all produce the same thing, they've discovered that the most efficient way to make exchanges is through a medium of exchange, something that gets in the middle of each of these trades, and that is money. That's the good that most people find to be most acceptable. So, the most accepted commodity in exchange becomes money. That's how money evolved. Why, at some point in history, many societies settled on the use of gold or silver as a commodity they would use for intermediating exchanges. So, if I want to part with my code, I can exchange it for money and then that money I can use to exchange for something else I want.

9:13I don't have to define somebody out there in the world somewhere who has what I want and wants my coat in exchange. So division of labor, market exchange, use of money, these are all basic ideas by which individuals pursue their selected ends and try to improve their and Material Well-Being. Now, in a market system, using money, prices become established. Instead of saying that my code exchanges for 10 loaves of bread, we could use a monetary unit and say my code is worth $100 and bread is $10.

10:04So that would tell us, in effect, that there's a 10 for 1 rate of exchange between Bread and this coat. So prices turn out to be a way of giving signals to people about the terms upon which they can make exchanges. And prices compress a lot of information because in the world we live in, prices are determined by the interaction of everybody who wants to make certain kinds of trade. Everybody who wants to sell jackets, everybody who wants to Sell Bread. Come to the market, they make the best deals they can, and out of their deals they settle on prices, and these market prices are the terms of exchange. And if somebody wants to consider whether a certain exchange can be made to improve his condition or not, prices give him the signal, the information that he can use to decide what's in his interest, The Theory of Money and Credit The Theory of Money and Credit The Theory of Money and Credit Supply it decreases and so price movements allow buyers and sellers to regulate their actions in a way so that they come into cooperation with one another and the amount that people want to buy and the amount that people want to sell comes toward equalization at a certain price and we call that market equilibrium. Real markets are always changing so they may not establish a price equilibrium for long

12:03in the market. That's the quick lesson there. Real quick, you've probably heard all of this before in some form in your encounter with basic economics, but we need to remember these basic items.

12:33This is not the common coin of the people you hear on television. They don't understand just what I told you in the last 10 minutes. They don't get it. They have a lot of crazy ideas about these things. Let's take a couple of examples to show how this way of looking at the world can be enormously helpful. The first example I'm going to give has to do with the Great Depression, which Doug French mentioned a while ago in relation to monetary policy. The Great Depression began in the middle of 1929 when the economy started to falter and firms began to produce less and some of them began to lay off workers and the economy began And then in October 1929 the stock market crashed and after that people began to more or less panic oh my goodness we're going to have a business bust, we're going to have a lot of unemployment as we have in the past when we've had financial crashes and business busts, so what should be done?

13:52Now this question of what should be done was actually a relatively new one in so far as the government was concerned. Although there had been business booms and financial booms and crashes for a hundred years or more, in general the government had not had any active policy to react to these. This was just something that went on in the world of commerce. If you were president of the United States and there was a business bust, say in 1893 as it was, President Cleveland didn't say, oh, well, the government has to do A, B and C to offset this. He didn't say anything of the sort. He said, you know, people should get their affairs in order. If bad businesses have been started that aren't viable, well, they should go bankrupt and we should get rid of the misuse of resources and move on to put the economy in a better condition. So President Cleveland didn't have an anti-depression Policy. In 1921, President Harding didn't have an anti-depression policy. But in the

14:58past, when there was no anti-depression policy, depressions were brief and relatively shallow. So beware when the government comes to fix your problem. You may be on the verge of having your problem magnified and made terrifically bad. In 1929, President Hoover, despite the The myth that he was a laissez-faire, do-nothing president was actually the other way around. President Hoover was a progressive. He had come to believe that government could and should take a variety of actions to offset business declines. And one of the things he had come to believe, not just Hoover, but many others at the time, had to do with something we call the purchasing power theory of wages.

15:45And what he believed was that if wages started to fall in one of these business declines, that made things worse, and so if you could just persuade employers not to cut wages when business got bad, that would help keep these declines from becoming too bad. So Hoover called a number of conferences, and late in 1929, he got together a lot of and he appealed to them, he said, look, don't cut wages, keep your wage rates up, don't put these wage earners in a condition where they are not able to buy as many goods as before, they'll just make things worse. So, whether because people wanted to cooperate with Hoover's appeal or for some other reason, in fact, many business people did not cut wages in late 29, in 1930, and even into 1931.

16:47So for about two years or so, particularly in certain parts of the economy where manufactured goods were made and particularly manufacturing goods used by other firms rather than by consumers, the wage rates stayed just where they had been. But meanwhile, prices of goods and services were falling in the economy, demands for goods and services were falling, and the only way that firms could adjust to the fact they were losing money, if they weren't going to cut The wages they paid to workers, the only thing they had left to them was to lay off the workers. In other words, the wage rate is a price. It's a signal. It's a signal that tells employers about the relative abundance of labor in the economy. If wages are high, that tells them labor is scarce. You've got to find ways to economize on it. If wages are low, they say labor is abundant or at least if wages have fallen labor is more abundant so use more of it

17:53but what was happening in 1929 30 31 because of these wages being held up was that employers were being told labor is no cheaper than before so you know you've got to you've got to act as if Labor is just as scarce as before, but it wasn't. Unemployment was growing. And in fact, because these wages were held up, it grew much quicker. And this increase in unemployment between 1929 and 1931 later got up to about 25% of the labor force and was the highest unemployment ever recorded in the United States. 25% unemployed, probably another 25% employed only part-time when they wanted full-time work.

18:45So it was a terrible situation for people in the U.S. economy, in part because the government distorted the signal of wage rates and led employers to lay off more workers than they would have if wage rates had been falling. So by distorting prices, by distorting signals, you distort incentives, you change people's behavior, you may make things worse by interfering that way, okay? Let me give you a second example. This one occurred in my lifetime, I remember it very vividly, it's known as the gas crisis or the energy crisis of the 1970s And it began in 1973. I happened to be living in the year 1973-74 in the Bay Area in California.

19:43And it was especially obvious there because Californians, perhaps more than even other Americans, love their automobiles. Very few of them ever leave their automobiles. They eat there, they sleep there, they raise their children there. So, Californians and automobiles are like that. The press always use that expression, Americans have a love affair with the automobile. Well I don't know if that's the right word, but the Californians had certainly developed a way of life in which the automobile played an integral role. So what happened here? How did this gas crisis come about? Well actually it came about in ways that didn't have anything directly to do with automobiles or gas lines at the stations or anything like that, it came about because in the late 1960s the rate of inflation began to increase, that is the purchasing power of the dollar began to fall quicker and quicker in the late 1960s.

20:48And that put the politicians all at quiver because they were afraid that they would be blamed by people for allowing this inflation, so they decided they had to somehow stake a claim that they were fighting it. And at that time, the Congress was controlled by Democrats and President Nixon, the Republican, was in office. And so, in 1970, the Democrats came up with the brilliant idea that they would put Nixon on the spot. They would enact legislation giving him the power to control wages and prices. And then, because Nixon, the so-called conservative, would never use that power, they could blame him for the inflation in the next election. Clever, huh? Well, Nixon to fool them because in 1971 he seized that power he had been given in 1970 and used it to impose comprehensive wage and price controls on the U.S. economy in the fall of 1971, along with some other things he did at that time. So price controls are put on everything including fuel, gasoline, fuel oil, anything made out of petroleum, and they were in existence when,

22:16a couple of years later, one of the periodic wars between Israel and its neighbors broke out, and at the same time something called the Organization of Petroleum Exporting Countries got together and agreed that they would act to keep the world's supply of oil from growing as So they squeezed down, because these countries altogether supplied an important part of the world's oil, they squeezed down on the rate at which they were allowing oil to be taken from their oil fields and put into the world's pool of oil. Now what that meant was that now there was less oil, or at least oil was not growing in supply at the rate it had been before, and so normally the effect of this would have been that oil prices would have risen.

23:08And from that, the price of things made out of oil, like gasoline, would have risen as well. That would have been a signal, a price signal telling people, oil is not as abundant as it used to be, use less. And that's the way prices are always acting. Prices move around telling people use more, use less, and people adjust to those incentives, bringing markets toward equilibrium. Well now, people should have been using less fuel or not increasing their use as quickly as they had been, but the price was still held down where it had been, because of the price controls. The price was telling them, fuel is as abundant as ever. Live it up. So people tried to buy fuel that wasn't physically there to be purchased. Now, the people who were selling it couldn't say, ah, this is great, people want to buy more of my product, I'll raise the price.

24:14They weren't allowed to legally raise the price. So what could they do? We had a situation There was an excess demand for gasoline that couldn't be rationed by the use of the price system, so it had to be rationed in some other way, and a variety of ways were tried, but the most important was that people just had to wait in line until they got to the pump, and if there was any fuel left when they got there, they got to buy it at the control price, and a lot of times the station would just come out and put up a close sign. And the people in the line had to say, well, tough luck, I'm almost out of gas, but I can't get any here. And they would wander around actually using gas, looking for stations that were open to sell them gas.

25:02It was bizarre. But this was another case where the government's action, namely the imposition of price controls, had distorted the market's signals, the operation of the price system, telling people Where they could benefit themselves by using more, using less. Virtually every time that the government interferes in the operation of the price system, and now we're talking about an almost infinitely large number of government programs, virtually every time the government interferes in the operation of the price system, the effect is to create false signals that lead people to use resources in a way In other words, it creates what economists call inefficiency in the use and allocation of resources.

26:03The price system is not just an artifact. Prices aren't there just because Mr. Jones at the corner store feels like charging a certain amount for a loaf of bread. The bread price is not really set by Jones at all. If he could set it, he might set it ten times as high. He can't because somebody else will set it lower and he'll have to lower his if he wants to sell any. So competition among sellers, competition among buyers brings prices into alignment. Producers don't control prices in a free price system fundamentally. The government interferes. It creates false signals. It creates inefficiency. It makes people actually worse off in the guise of protecting them from rapacious sellers.

26:59This is a political bill of goods. You know enough basic economics at this point never to buy that political bill of goods. If you ever see a political proposal to control prices, such as, for example, the recent health care reform bill, recognize that what you're seeing is something that will only make matters worse. And do not give your approval to politicians that propose to ruin your world in that fashion. Thank you very much.